Hi Steve,

You seem to be the "go-to" person for options so thought I'd ask a question.

 I'm just starting out in options and have started paper-trading using virtual accounts.  I'm also using a strategy program that uses profit/loss diagrams and other calculatons to "predict" profit and losses based on the price of the underlying stock.

The issue I'm facing is that the profits predicted by the P/L diagrams don't always match reality.  In some cases, the prediction will be for a gain yet the reality will be a loss.  And this factors in all the commissions, so that's not the problem.

What I'm trying to understand, and something I vitally <i>need</i> to understand before I start using real money, is how to use the various options tools that are out there.  The P/L diagrams seem to my novice eyes to be misleading but everyone uses them (and they seem to be the basis for McMillan's recommendations and he's supposedly the main guru), so perhaps I'm using these diagrams  incorrectly.  There's also the options pricing calculators.  Then there's just following the options prices in real-time, which isn't good for what-if scenarios, but tells you where you actually stand.

In sum, there's a lot of tools and methodologies for working out options strategies, but I've never seen anything that puts these tools into perspective.  Could you offer some advice as to how to use these tools?  For example, do you start with the P/L diagrams, and if so, how do you modify their projections to account for what might actually happen, i.e. the fact that the bid and asks don't necessarily conform to the price predictions of the diagrams.  And where do the pricing calculators come into play?

Or, if you don't use tools at all, maybe you can just describe the back-of-the-envelope calculations that you do to determine what might be a winning strategy under varying conditions.  Maybe that's a bit simplistic given that the planning of complicated strategies like spreads is a lot different than that called for with simple calls or puts, but I'm just trying to find a starting point.

Thanks very much,

kate 

My two bits:

Option prices are not determined by formula, they are determined by volatility. A one month expiration call on a volatile stock like LDK (or put) at parity ( 40  call when the stock is at 40) will cost you a FIVE dollar premium. On a stock like Sun Micro there is virtually no premium. If you are planning a complicated bet on a stock , pick one that suits your goals.  An arbitrage trade to take advantage of premium differences would probably work better for Sun Micro, with its stable price structure, than for LDK, which can jump or down ten points a day.  

Volatility is another term for "psychopathology" or craziness and arbitrariness. You need to be crazy to invest in stocks like LDK.

I guess what I really want to say is that if there was a winning strategy based on software analysis, the big boys (NYSE< GS< Lehman, and the hedge funds would already be exploiting it with their teams of PHDs and super computer models.  The chances YOU will find a winning strategy in your spare time on an excel spreadsheet are somewhat less than a team of 20 highly intelligent pros with unlimited funds and computer time.

In other words, stick to what you know. 90% of options traders lose money. Buck the trend and stay out.

I buy and sell calls and puts, as insurance and for income (covered calls) I never waste my time on exotic strategies of selling 3 month out out of the money calls and buying two month in in the money puts.  Or whatever. In order for those strategies to WORK the market has to go the way YOU want it to.  If you already know which way the market is going, why not buy equities? 

Thanks for the reply, Ernie.  I see I didn't get across the point I intended... my fault and.I apologize for sending you down the wrong path.

I'm actually not looking for a "winning solution", despite having written those words.  I'm looking for a way to test strategies and figure out where my exit point should be.  (This is assuming I decide that options are a way to go, which I'm not sure of at this point.  They offer a lot of flexibility but also look like a great way to lose money...but I digress)

In stocks (as opposed to options), you can plug a target price into a spreadsheet and determine that getting out at $50 or $60, say, will give you a profit of 40%.  I'm looking for a similar tool  for options.  I thought that tool would be the P/L diagrams and/or the software  programs built on them, but found that they didn't give me the correct answers when I plugged in various target prices.  Apparently these P/L diagrams are theoretical, which is why I can't figure out why people use them except to get a general sense of the strategy. 

To put it another way, I never buy a stock without knowing where my general exit point will be.  How do I know how to do that with options?  Should I just ignore the fancy software that deals with the underlying STOCK price and just figure out what OPTION price I should sell at?  That's the easy way out...plug the open price and various close prices into a spreadsheet and determine which close price will give me a decent profit.  But that doesn't help determine whether that price is even reachable or not via a particular options strategy.

So, do any of you guys use tools or do you just play it by ear, open a position based on little more than an expermental mood, watch your position, hope for the best, and close when it "feels right"?  I'm hoping for something a little more rigorous than that.  

OK.  Let me try again.

Do you have access to level 2 streaming quotes? If you don't, option trading is probably best limited to LEAPS.  As I generally buy deep in the money and "large" " quantities of options, I pay less for volatility. The close to the strike price, the more you pay for time delay. And time delay is the karma of options. The minute you make a trade the clock starts ticking. An even money option  (20 call with 20 underlying) may have a premium 500% higher than a 15 call on a 20 underlying.   You will pay 5 bucks more, but far less for  time delay. That is an option that expires in a month, for instance, has a much lower premium, the further in the money it is.

 Unless you are looking at streaming quotes it is hard to determine  what premium you are paying.   If you don't know that, you don't have a chance of plotting a strategy. A five dollar premium on a volatile stock like LDK is typical for an at the money option ( 50 call with  underlying 50 might cost you five bucks for  a one month duration. )  So your strategy needs to grasp that you will probalby lose $1.25 a week in volatility premium as the option ages. Thus a 50 stock that goes to 54 in four weeks means that you have paid $5 for the privilege of saving $4 if you exercise or sell. (You sell the option you paid $5 for a month ago for the $4 it is worth now, as the stock has appreciated from 50 to 54.   LOSE!!

 
But if you bought strike  40 calls on the underlying 50 stock , you would probably have paid the $10 difference plus a much smaller volatility premium. Maybe $1.50.  Thus the $11.50 cost of the option you pay when the stock is at $50, is less than you will sell the option for by appreciation less premium. In this case, if, in as the previous example, the stock appreciates to 54, the option at expiration will appreciate to $14 from $11.50.  WIN!  You bought deep  in the money at $11.50 and sold at $14. The $1.50 premium you paid evaporates as the time period shortens.

I hope that makes some sense. It is pretty basic. Options can get quite compicated, but that just means more opportunity to make or lose money.  Stick with what you understand, and by all means do some fantasy trades and see what happens. 

I think a lot of option traders stick to a few stocks and indexes and play hunches. You can get technical and plot put call combos that are very exotic and guarantee and income if all the parameters are met, but a static market can often destroy those strategies. Options are extremely powerful ways to manipulate money, but they have no loyalty and can help you lose money in a jiffy as well.

 

Hi Ernie,

Yeah I have access to L2, but it's for stocks, not options.  I can only get streaming options quotes from my broker if I trade 20 options, but I have yet to trade any options.  I want to educate myself first before I start investing any real money.

But in the stocks I've been looking at, the premiums don't change that often.  I get real-time quotes for the options...just not streaming...and when I refresh, they don't change that much.  So I was assuming as a start point that the volatility of the quotes was the least of my worries.

I just want to be able to plan a transaction and anticipate what might happen, and calculate when to take profit or minimize a loss.  And I want to do this AHEAD OF TIME, instead of having to sit in front of my computer and watch every tick in real time.  With stocks, I have a sense of where the price is going, I have mental stops and I know where I should take profit.  But I don't have that with options, and it seems no one else does since they usually just cite rules like, "always use the highest delta", or "with covered calls, always go slightly OTM", but they can't explicate any real plan for when one should liquidate an option, roll up or roll down.  Maybe I'm reading these people wrong, but they don't seem to use a spreadsheet, but rather are "winging it".  That seems like dangerous territory to me -- pouring out money without a safety net.  If that's the way options trading is, I'll take a pass on it except for basic puts and calls, since I don't throw money around unless I can anticipate what might happen to it.

And that requires a spreadsheet or something similar.

Is the bottom line really that options aren't amenable to spreadsheets? You just have to work with certain principles - implied volatiliy, historical volatility, the Greeks, etc.  - and with some muddy sense of that in mind, go ahead and roll the dice and hope for the best? 

I imagine a lot of option traders wing it.  A lot trade options to take advantage of volatility,

In the money option prices will usually directly reflect a stock price change, 10 cents at a time.  Though the further in the money you go, the less true that is. 

 I guess to make it simple, I set percentage guidelines for loss and win.  And they are fairly low. I would rather make a base hit than a home run.  Four base hits are the same return as a home run.

 
I think your plan to stay out until you have a plan is a good one. 

AFAIAC roll the dice applies to stock and options, options more so. I mostly use options as insurance to cover my gains.  Or as insurance against loss. 
 

Hi Kate.

I am not sure if I am the Steve you are talking about, but I want to give you a reply.

First of all, there are many option strategies. What strategy are you using? For instance, you can speculate by going long on an option. Also, there is selling covered calls or puts, which are also popular strategies. There are also combinations of options in all sorts of complex trades.

If you are just starting, I would recommend a very simple strategy. The two simplest strategies that I know of are 1) going long on a call and 2) selling covered calls.

Selling covered calls would be the most conservative, but it also depends on the stock. Going long on a conservative stock can be safer than selling a covered call on a volatile stock, so it depends.

You may be getting differences in the predicted profit vs realized profit because of volatility estimates, and also volatility changes. There's also the greeks, or delta, gamma, theta, vega, etc, which measure degrees of change in an option price vs. the price change in the underlying security. These greeks change not only with the stock selection, but also which option contract you buy (in the money or out of the money). So it can be tricky to predict exactly what will happen between an option price at any moment vs the stock price. It is frustrating to see a large move in the stock price and only a fraction of that move is represented in the option price. Generally, the largest moves in the option price would be for ITM options closer to expiration and less movement in the price of OTM LEAPS, for example.

I am a fairly conservative guy when it comes to options, so my main strategy is covered calls, but my second strategy is buying ITM or close to the money LEAPS. Right now, I am looking at interesting positions in the jan09 calls, for example. Buying calls is pretty risky due to the time decay, so I tend to go long over longer periods of time. When I speculate on short term calls, it is usually on some event as a catalyst within the month, and that feels like gambling, almost. I sell covered calls on months close in and buy the LEAPS.

For more complex strategies or frequent trading, other more experienced traders would need to help you with that.

Good luck.

Steve